First Quarter Market Discussion
A temporary pause in the impact of macro influences abroad, improving economic numbers in Europe and China, and attractive valuations provided broad strength for international equities. Lack of the unexpected in foreign markets was in contrast to the U.S., where investors appeared concerned about political turmoil, elevated multiples for equities, and uncertainty as to whether reality would live up to heightened growth expectations.
The lack of clarity in the U.S. set a defensive tone and investors took a risk-off stance. As a result, the Yen strengthened but the effect was muted for Japanese exporters and industrials.
Emerging Markets were particularly strong as optimism about a softening dollar overcame concerns tied to softening oil prices. Buying was broad with the majority of sectors up for the period. Excluding Energy, economically sensitive sectors led the rally.
Security selection was positive with names in Consumer Discretionary and Information Technology (IT) helping the portfolio outperform the Russell Global® ex-US Small Cap Index. The Fund’s holdings in Materials and Energy detracted.
On a regional basis, Asia was a source of strength, with holdings in Hong Kong, Japan, and South Korea among the top contributors. Brazil was also a strong performer for the Fund.
Impressive acceleration. Consumer Discretionary was a key driver of relative strength and contained a top performer. ZhengTong Auto Services (1728 HK), a Chinese auto dealership with 97 outlets in 32 cities across the country, was up sharply as investors began to anticipate higher luxury car sales, which make up 70% of the company’s volume and account for 86% of revenue.
Originally we were attracted to the business for its improving bargaining power with auto manufacturers, sales growth tied to a growing middle class in China, and its financing unit, which gave ZhengTong a competitive advantage in attracting customers.
Following the significant appreciation in share price, we trimmed a large portion of our exposure based on valuations. While shares are still at a discount to its peers on a price-to-book basis, we believe much of the near-term good news may already be priced into the stock.
Energy drain. Following several months of firming prices, oil fell based on investor concerns about excess reserves coming to market. Questions about whether an agreement among members of the Organization of the Petroleum Exporting Countries to cut production would be renewed also weighed on prices.
Our holdings in the space underperformed the market and included a key detractor. Canada-based Cardinal Energy Ltd. (CJ CN) was down due to the decline in crude prices. Despite the setback, we believe the company’s valuation, strong balance sheet, and high-quality energy assets make it a compelling long-term investment.
After the recent decline, Cardinal is trading at just 0.74x book value, and its dividend yield is more than 6%. Because its debt level is minimal, we believe the dividend will remain even if low oil prices persist for the intermediate term.
Decline rates for the company’s oil production are much lower than those of its competitors. As a result, we believe Cardinal should be able to maintain its output levels without taking on significant capital expenditures.
Signing on the digital line. Our holdings in IT produced strong results, and the group continues to be a source of attractive opportunities. We initiated a position in Wacom Company Ltd. (6727 JP), a Japan-based technology company that makes digital stylus products for consumer tablets and solutions for high-end graphics used in the professional market. The company has recently launched several new professional products including one with the ability to support 3-D design. These offerings should drive replacement demand and lead to top-line growth. Despite the improving business cycle, the company continues to trade in line with its trough revenue of the past few quarters. Given that a sales cycle typically lasts up to four years, we believe shares are in the early stages of a recovery and that its valuation of just 2.4x price-to-book versus a five-year average high of 4.0x provides significant upside.
We’ve taken strength in several of the Fund’s holdings as an opportunity to harvest gains and redeploy assets elsewhere. We’ve sold on strength in Brazil but remain overweight to Emerging Markets as a whole. The Fund’s names in Japan have also outperformed, and our recent trimming in the country has resulted in a modest underweight to the region. The move reflects our approach of mitigating risk and is not a sign we view Japan’s prospects negatively.
Companies in the UK remain attractive based on valuations, a weak currency, and modest expectations for the country’s economy. The Fund remains overweight to the area.
Outlook and Positioning
We expect recent calm in the global markets will give way to increased volatility in the months to come. Fallout from the Brexit vote will take on greater importance now that the UK has triggered Article 50 to begin the process of ending its membership in the European Union. China appears to be in the early stages of an economic uptick and its efforts to stabilize the Yuan could have spillover effects around the globe. Questions about the strength of European banks is an additional wildcard that may have a material effect on the economy as well as equities.
We cannot control macro factors but, as bottom-up investors, we can capitalize on opportunities that arise in response to external events. As the chart below shows, the performance gap between Emerging Market and domestic stocks is wider than it’s been in the past 20 years. Additionally, valuations for international stocks remain significantly more attractive than U.S. stocks. We view the discrepancy as an opportunity to own a portfolio of businesses trading at compelling valuations that is diverse by region, sector, and industry.
An Unsustainable Gap?
Source: Bloomberg L.P. and Heartland Advisors, Inc., 7/31/1996 to 3/31/2017
Past performance does not guarantee futures results.
Japan remains attractive from a long-term perspective, but strength in economically sensitive areas has made bargain hunting more challenging. The UK continues to be fertile ground for investment ideas due to attractive valuations and more modest expectations compared to U.S. markets. We are also seeing opportunities in Emerging Markets such as Brazil. Inflation has moderated and interest rates are improving – both should provide a tailwind to well-run companies.
Our focus remains on finding sound businesses with strong management teams that have a history of prudent capital allocation decisions. We believe owning dividend paying companies with robust balance sheets provides downside protection while allowing for upside potential.
Thank you for the opportunity to manage your capital.